InvestorQ : As an equity market trader what are the common misconceptions that I need to avoid in the stock markets?
prachi Patwardhan made post

As an equity market trader what are the common misconceptions that I need to avoid in the stock markets?

shrinidhi Rajan answered.
2 years ago

As much as there is wisdom in the markets, it also has its own share of perceptions and misconceptions. The funny part about investing and trading myths is that if your premise is wrong then your conclusion is also bound to be wrong. Let us look at some very common misconceptions around trading in the stock markets.

As a trader, it is returns that matter and not risk

You must really be crazy to think like that. More people have made money in the equity markets by focusing on risk than by focusing on returns. Once you learn to control and measure your risks your returns in the markets will automatically follow. It does not matter whether you are a small trader or a billionaire trader; you will effectively have to trade with finite capital. As long as capital is finite, the core challenge is to manage your risk.

Let us look at it the other way. Say you took a wrong decision and lost 50% of your capital. Now on this smaller base you need to earn a 100% return to come back to parity. Which is why risk becomes so important? Risk management is not just about putting stop losses but it is also about when you should hedge your equity holdings and when you should stay out of the market altogether. The biggest challenge for any trader or investor is to ensure that the capital does not get depleted beyond a point. The bottom-line is that you must put more focus on managing risk. The returns will follow logically.

I focus more on the stock price movements than on what the company is doing

The company behind a stock is more important than the stock itself as that is the underlying that assigns value to the company. Don’t ever try to invest in a company unless you understand basics about its product, market and its financials. As Warren Buffett said, “Behind every stock is a company with a business. Try to understand how that business is doing”. That is critical for an investor. Nobody has ever made money by consistently timing the market, or through bottom fishing or by trading each shift in the market precisely. Even the great trader, Jesse Livermore, had to live through multiple bankruptcies during his trading career despite being regarded as one of the sharpest traders in the history of the stock markets. Understanding the company behind your investments and understanding the trading game is of paramount importance.

Large caps are better bets than mid caps

At certain points in the market, this perception may be correct but it also risks being erroneous over the long term. The problem is that most of the large caps are over-owned and over-analyzed. A stock like Infosys may have over 50 analysts tracking the stock. Where is the scope for Alpha? The answer is there isn’t. You would have made a fortune had you purchased Sun Pharma or Lupin more than a decade ago. Today the story is well know, which possibly explains why it is so hard to make money on them. On the other hand mid-caps have more focused business models and lower levels of debt. It is alpha versus beta.

The best performers in the last 5 years are actually mid cap stocks. Stocks like Motherson Sumi, Lupin, Eicher Motors, Page Industries and TTK Prestige have multiplied many times over in the last 7-8 years. During this period, a large cap stock like Reliance, Tata Motors or ONGC may have actually gone nowhere. It is these mid-caps that eventually transform into large caps and enable you to make that big return. Large Caps can perhaps just about better your debt investments.

I prefer past performers so I don’t have to worry about future returns

Try telling this to someone who has purchased Maruti or Tata Motors or even Tata Steel in the last 1 year. Warren Buffet used to occasionally joke that if the past was what the market was all about, then librarians and archaeologists would be the wealthiest people in the world. Unfortunately, the market is not about focus on past performance. That can at best give you a comfort level. But that does not make your investment grow. Remember, a company with a great track record like TCS or HUL would already be trading at rich valuations in the market. The problem with past performance is that it may have operated in a different environment. For example retail companies are competing with online stores; established hotel chains are competing with start-ups like AirBnB and Oyo Rooms. If you had focused on past models and bought MTNL, you would have missed out on Bharti. That, probably, nails it!

Markets are becoming complex, I can only make money with algo trading

That depends on whether you are talking about better returns or better execution. Algo based strategies may at best give you better execution. You still make money by identifying a good stock and holding on to it till you realize its full potential. Why is it so? Firstly, not everything that is complex is great. As Peter Lynch used to say, “A great idea should be so simple that you should be able to illustrate it with a piece of chalk”. Take the case of Eicher Motors in 2009. A growing market, hardly crowded, low capital requirement and a high ROE was a classic combination to create wealth. The stock has appreciated nearly 150 times in the last 8 years! Similarly, Britannia multiplied shareholder wealth with a single-minded focus on the premium biscuit segment. That is how simple it is! No algos were involved.

The moral of the story is that some of the most important stocks are based on common sense and you don’t need to use sophisticated algos for the same. All you need is to be able to identify the growth story or the disruption well in advance to be able to capitalize on the story. That is it.